What The MF Investor Wants To Know ?

In DSIJ's Investor Awareness Programmes, we found that some common questions keep bothering investors everywhere. Here we answer some of the most repeated and important questions which will help you decide about MF investment easily. 

Are liquid funds more tax efficient than fixed deposits?



We at Dalal Street Investment Journal, as part of our Investor Awareness Programmes, keep interacting with investors throughout the year. Last fiscal year (FY19), we did 68 such events covering the length and breadth of the nation. In the process, we had a face to face interaction with more than 15,000 investors. There were some questions that kept on repeating irrespective of which part of the country we went. The following story is a culmination of trying to address some of the most important worries of the investors.

How many funds should be there in my portfolio?

Just as they say, 'one size does not fit all', giving a single number to how many mutual funds you should have in your portfolio is a bit difficult to say. It will depend upon your financial goal and risk appetite. Different goals of yours require wdifferent set of investments, which means different set of funds for you.

Nevertheless, if you consolidate your investment based on goals, the total number of funds should not go beyond 10-12.

For example, your child education and retirement may require you to invest in a large-cap fund, among others. Again these funds should be from different categories. These categories should also not go beyond 5-7. These categories of funds should have weightage based on your risk tolerance and financial goals. As you near your retirement, you should be more conservative in your approach and shift your funds accordingly to categories with lesser risk.

The major categories that should be part of your portfolio in equities are large-cap, mid-cap, small-cap and international funds. When it comes to debt funds, long duration, medium duration and short duration should be part of your portfolio. Depending upon your goals, an ideal weightage should be arrived at. It should be rebalanced at periodic intervals so that proper weightage is maintained and your goal is reached.

If you follow the above rule, your portfolio will be less cluttered and will be easy to track, adequately diversified and, at the same time, it will help you to reach your financial goals.

Debt funds are risky, so why are you recommending them now? Especially after the IL&FS fiasco!

Debt funds are one of the most important constituent of anybody's portfolio. The exact weightage, however, will depend upon individual's risk appetite and investment objectives. You can minimise the debt proportion, but you cannot do away with it altogether.

In the last one year, debt funds have remained in the news for the wrong reasons. Hence, investors are worried about their investments in debt funds. A careful analysis of data, however, shows that, on an average, debt funds have remained the best performers in the last one year.



Going ahead, as interest rate goes down due to fall in the yield due to various reasons, we believe that debt funds will remain attractive, especially long duration funds.

How to choose the best performing MF scheme?

There may be various funds that would be performing well but these funds may still not be best for you for the simple reason that they might not go with your risk profile. Hence, before going for the best mutual fund, you should first understand your risk tolerance and investment objectives. These two factors will help you to decide which mutual fund scheme is best for you. Once you have zeroed down on what type of MFs you want to buy, the next step is to investigate those categories and funds in those categories.

Few things other than the 'expense ratio' have direct impact on the performance of the funds. To run a mutual fund, the fund houses requires money to pay salaries to the analysts and fund managers and pay rent and electricity and cafeteria expenses before your cash can even be invested! The percentage of assets that go toward these expenses is known as the expense ratio. Higher the expense ratio, the lower might be the returns on your investment, but not necessarily.

The next important factor is portfolio of the fund. It is ultimately the portfolio that delivers everything about the fund. All the important ratios of the fund such as risk, return are derived from its portfolio. Therefore, it is important to check the portfolio of the funds. It should be in conjunction with your investment philosophy that you are comfortable with. So if you believe that 'growth' is your style of investing, you can look for those MF schemes that have 'growth' stocks in their portfolio.

There are rating agencies that follow 5 Ps to come out with best performing funds. These 5 Ps are People, Process, Parent, Performance, and Price. You can use these 5 Ps, along with what we explained earlier, to come out with your best performing MFs.

What is the importance of expense ratio and are the funds with lesser expense ratio better for investment?

Your mutual fund investment is managed by a team of professionals and they do not come free. Besides, there are many other expenses, such as expenses of custodian and other administrative costs. All these costs come under the expense ratio, which is deducted from the net assets of the fund. Hence, the net asset value, better known as the NAV of the fund, is net of such expenses. The following table shows average expense ratio of different categories of funds at the end of April 2019.



It is always believed that higher expense ratio may be eating your returns and hence higher expense ratio may mean lower returns going forward. To understand this, we plotted the expense ratio of all the equity funds, excluding index and ETFs, against their next one year returns. We do not see any strong correlation between them.


We went one step further and tried to understand the relation between expense ratio and one year forward return. We see that except for large-cap fund, there is negative correlation between expense ratio and one year forward return of the fund.



Therefore, although at broader level, the expense ratio may not have much of impact on fund's returns for the next one year, it definitely has impact at the micro level, especially for small-cap funds.

Is it wiser to select those MF schemes which have higher AUMs? How important is higher AUMs while analysing any fund?

It is one of our common beliefs that bigger is better. The root cause of such belief lies in the fact that the biggies have survived various cycles because of their good performance and hence they have become large. There might be truth in this assumption, but this is not the only truth. To get a better understanding, the funds need to be bifurcated between equity and debt.

Equity Funds:
For equity funds, size may not be a better criterion to select funds. This is because different categories of funds have different universes for stock selection. In case of a large-cap fund, there is opportunity to invest large amount of fund as the stocks that are large-cap are liquid and investment can be made without much of an impact cost. However, in the case of small-cap funds, after they attain certain size, there is impact cost of investing in stocks. This is the reason why many small-cap funds stop lump sum investment after they reach a threshold AUM. To understand this, we did the same study we did with the expense ratio given above.



The above chart shows that, there is no clear trend between AUM and future returns. Nonetheless incase of category wise we see that as fund size grows there is decline in returns other than large cap fund.



Debt Funds :
In case of debt funds, the size becomes important as we can see large funds can distribute fixed expenses over a large number of unitholders. This can bring down the expense ratio and thus reduce its impact on fund returns. Large funds can also negotiate better rates with issuers of debt. On the other hand, if a large debt fund is faced with huge redemptions, the market may not have adequate depth to bail it out. So, it is better to avoid the extremes of large and small funds.

Is it possible that Indian economy keep growing and the equity returns keep falling and thus my MF investments yielding negative returns even if I remain invested for 10-plus years?

It is not impossible, but the chances are remote that despite the Indian economy doing good, your MF investments will yield negative return for you. In investment, it is not the starting point, but also the end point that is important. So, if you had invested in the market taking Sensex as a proxy to the market between 1992 and 1994 and remained invested for the next 10 years, there was high probability that you would have made losses despite remaining invested for 10 years. During this period, the size of the Indian economy more than doubled from USD 0.3 trillion to 0.7 trillion. Nonetheless, in the history of the Indian stock market, only 5% of the times the broader level index has given negative returns in a 10-year period.

In case of mutual funds also, there are possibilities of such a negative return period for such a long duration. Nonetheless, this is limited to a few sectoral funds. For example, if you had invested in an infrastructure fund at the start of January 2008, the NAV would have been lower than 2008 even in 2018 for some of the funds.

Hence, it is important that you should periodically review you portfolio and get rid of underperforming funds, even at a loss. Moreover, sectoral funds should have limited exposure in your portfolio.

What are hybrid funds and how do I select the best hybrid funds?

Hybrid funds are ones that invest in equity, debt and other asset classes. Depending upon the mix of different assets in the fund, the capital market regulator, Securities and Exchange Board of India (SEBI) categorises hybrid funds into six categories: conservative hybrid fund, balanced hybrid fund, aggressive hybrid fund, dynamic asset allocation, multi-asset allocation, arbitrage fund and equity savings.

Since there are six types of hybrid funds, you can select the right one depending upon your risk profile. If you are risk averse, go for conservative hybrid funds that have large portion of their corpus invested in debt, which is less volatile than equity investment. Hybrid funds are generally advisable for investors who are new to investment and lack risk taking abilities or are conservative investors.

Is investing in index fund better than investing in equity diversified funds?

There are two ways in which the mutual funds are managed. Either they are actively managed or they are passively managed. The fund is said to be actively managed when the fund manager takes the investment calls based on his knowledge and experience to generate alpha over the benchmark. Here the fund manager can have the stocks from the universe as prescribed by the SEBI in its recategorisation circular. However these funds can hold stocks with weightages different from the benchmark followed by the fund.

The fund is said to be passively managed when the fund only tracks the benchmark it follows. It invests in the exact same stocks and in the exact same proportion as its benchmark. This means that technically, you are investing in an index via mutual funds or ETFs. It may have some amount of tracking error, though.

The diversified equity funds are actively managed and index funds or ETFs are passively managed. As stated earlier, in actively managed funds, the fund manager can take investment calls and so there is a possibility of the fund generating alpha. India is one of the strongest emerging economies in the world. So, active fund managers have a chance to generate alpha over the benchmark. This is largely for mid-cap and small-cap funds where the investment universe is large and there are many less-researched companies. In the case of large-cap funds, which are well researched, it has been found that index investing generates returns that are superior than actively managed large-cap funds. Hence, passive investments like index funds and ETFs are the future of investment. According to various studies carried out across the world, it has been found that in maximum instances the index performed better than an actively managed portfolio.

What are risks of investing in liquid funds?

Many intermediaries were marketing liquid funds as an alternative to your savings bank account as liquid funds give better returns than your savings bank account. However, the risk factor was not considered while advising the same, until IL&FS episode hit the liquid funds. This is when people started understanding that liquid funds are not 100 per cent risk-free as compared with savings bank account. When it comes to risks, then the interest rate risk is negligible as they invest in low maturity debt instruments and money market securities. They are usually prone to other risks such as credit default risk as they are not insured like your bank fixed deposits or savings bank account. So, liquid fund needs to be viewed as a investment vehicle that involves risk, whereas your savings bank account is a savings vehicle and is risk-free.

Are liquid funds more tax efficient than fixed deposits?

Tax is one of the major factors one considers before investing. There are people who give more weightage to tax, even more that their financial goals and returns. When it comes to taxation, it is important to understand what constitutes taxable income. Taxable income is the income on which tax will be calculated. Any gain from fixed deposits and liquid funds forms a part of the taxable income. There is a difference between realized and unrealized gain, and only realized gain is considered as taxable income. This means that unless you realize your gains, these do not come under the purview of taxation. In the case of fixed deposits, the interest that you earn is credited to your savings bank account and hence it comes under the purview of tax. On the contrary, the gains from the liquid funds do not come under the purview of tax, unless you sell the funds and realize the gains. This means that fixed deposits gains are realized automatically and liquid funds gains are realized when you actually want it to realize. When it comes to tax treatment then, any gains from liquid funds before completion of three years is considered as short term capital gain and is taxed similar to fixed deposits. However, if the gains from liquid funds are realized after three years, then you enjoy indexation benefit where the effective tax is less than that of your higher income tax slab. However, for lower tax slab individuals, fixed deposit would be a better option than liquid funds as far as taxation is concerned. However, whether to go for liquid fund or fixed deposit depends on your requirements. If we look from risk perspective, if you are a conservative risk taker and do not wish to take the risks involved in liquid funds, then fixed deposit would be a right choice for you. But if you can take the risk, then liquid fund would be a better bet. You have to also consider your liquidity needs. So, if you are sure that you are not going to need the money till the end of the tenure, then fixed deposit would be a better choice for lower tax slab individuals. However, if you require high liquidity, then investment in liquid funds is a better bet.

Which funds are good for retirement planning?

While planning for retirement, it is better to adopt the following procedure. First, you need to calculate the retirement corpus that you require to fund your post-retirement requirements. Then, to achieve this corpus, you need to calculate how much you need to invest in lump sum and through SIP. Now, the question is how to calculate the retirement corpus? To calculate the retirement corpus, you need to calculate your monthly expenses. Then you have to inflate the same with the inflation rate till your retirement year, which will give you the inflationadjusted monthly expenses required at the time of retirement. Then, you need to calculate the present value of all the future cash flows considering the real rate of return and life expectancy. This present value is your retirement corpus. Then based on the calculated retirement corpus, you need to calculate the amount of monthly SIP and the lump sum required to fund this corpus considering the expected rate of return on investments and tenure of investments, which is from today till your retirement age. But as they say, one size does not fit all. So, it is important to assess your risk profile and decide the investment tenure, based on which you can define as to which asset class suits your requirements.

In case of debt funds, the size becomes important as we can see large funds can distribute fixed expenses over a large number of unitholders.

The following example will help you to determine your monthly SIPs for your retirement fund. The actual fund selection will depend upon your risk profile.



Assuming everything being the same from the above table, it gives you the SIP you required for different age levels and monthly expenses.



I have a new born baby boy and I would like to buy a MF fund now so that I can plan for his higher education 18 years down the line. Which fund or funds are perfect for such planning?

As said earlier, rather than focusing on investment in funds, it is prudent to focus on investing in asset classes. Like retirement planning, here too you first need to understand how much you would require for your son's higher education in today's terms. This means that if your son was to take higher education today, how much would it cost? Then inflate the same with an appropriate inflation rate to arrive at the corpus that you would require to fund your son's education. Then, based on the corpus, calculate the required lump sum and SIP with the help of expected rate of return on investment. Before deciding on investments, it is important to assess your risk profile and tenure of investment which, as you mentioned, is 18 years from now, which is a long term period. As your investment horizon is long term, investing more in equity mutual funds would be a better idea, specifically in mid-cap and small-cap funds, provided you are an aggressive investor. In the last ten years, mid-cap and small-cap funds on an average have given annualized returns of around 16%.

Hence, if currently you are looking for a course that is costing around Rs. 20 lakh, by the time your child becomes 18-year old, the cost of the course would be around Rs. 48 lakh, assuming course fee increases by 5% every year. For that, you need to invest Rs. 4935 every month, assuming return on your investment at 14% per annum. The following table will give you an idea of how much monthly SIP you need to do for your child's education assuming current cost of Rs. 20 lakh and inflation of 5%.



Is MF investing safe if I buy through PAYTM?

Any investment platform, be it PayTM or any other, have to get registered with SEBI (Securities and Exchange Board of India) before it can distribute products. Even if these platforms distribute direct plans, they need to follow all the guidelines as may be prescribed by the regulator.

Few months back, PayTM had generated a lot of anger due to the poor customer experience and lot of bugs in the app, with no specific customer care number to contact for resolution of issues. However, the company has recently fixed a lot of bugs and has also provided customer care section to resolve your queries. So, it is definitely safe to invest via PayTM. But we would urge you to directly invest through the respective fund houses website as it will give you a lot of insight about the funds available and their factsheets. This would indeed help you to understand the product before investing.

Is direct investing safer and better than investing through a distributor?

There are various ways in which you can invest in mutual funds. Majority of the mutual funds have direct plans and regular plans. To invest in direct plan, you can invest through the fund house's website or through its app. You can even invest in direct funds with fee-based RIAs. There are various online platforms available from which you can invest in direct plans. When it comes to regular plans, there are some online platforms through which you can invest in regular plans. Also, there are various intermediaries such as mutual fund distributors, independent financial advisers and institutions like banks for investing in regular plans.

Direct investing and investment through distributor both are safe. But which is better? This depends upon your requirements. If you just wish to invest and you know where to invest and you don't require any research or advice, then investing in direct plans through fund house's website would be a good option. If you don't require advice, but do require research, then investing via distributor would be better. However, if you require both advice and research, then investing via fee-only RIA would be a better option. To get a deeper insight, kindly read our special report in this issue before deciding which route to take for investing in mutual funds.